Back in ancient times when I worked at esteemed weekly newsmagazine U.S. News & World Report, I always loathed the annual college rankings report. Like all cash cows, however, the college guide was a sacred cow, so I just shut up about its obvious statistical absurdities and inherent mendacity. As a lesson in the evils of our times, it is perhaps inevitable that the college guide is now the only thing left of U.S. News.

A story in today’s New York Times reports that Claremont McKenna college has now been caught red handed submitting phony data to the college guide to boost its rankings. But the real scandal, as usual, is not the occasional flagrant instance of outright dishonesty but the routine corruption that is shot through the whole thing. … To increase selectivity (one of the statistics that go into U.S. News’s secret mumbo-jumbo formula to produce an overall ranking), many colleges deliberately encourage applications from students who don’t have a prayer of getting in. To increase average SAT scores, colleges offer huge scholarships to un-needy but high scoring applicants to lure them to attend their institution. (The Times story mentioned that other colleges have been offering payments to admitted students to retake the test to increase the school average.)

… One of my favorite bits of absurdity was what a friend on the faculty at Case Law School told me they were doing a few years ago: because one of the U.S. News data points was the percentage of graduates employed in their field, the law school simply hired any recent graduate who could not get a job at a law firm and put him to work in the library. Their other tactic was pure genius: the law school hired as adjunct professors local alumni who already had lucrative careers (thereby increasing the faculty-student ratio, a key U.S. News statistic used in determining ranking), paid them exorbitant salaries they did not need (thereby increasing average faculty salary, another U.S. News data point), then made it understood that since they did not really need all that money they were expected to donate it all back to the school (thereby increasing the alumni giving rate, another U.S. News data point): three birds with one stone! (I gather the new Case law dean has put an end to these shenanigans.)

Worth reading the whole thing (even though Budiansky’s site has one of those annoying and anti-social ‘if you cut and paste text from my site, you will get unasked for cruft about how you ought to click on the original link added to your pasted text’ installations).

The article discusses a report by a court-appointed examiner on the finances of Lehman Brothers prior to the bankruptcy of the company. The report shows that while the shareholders of Lehman Brothers lost plenty of money in the bankruptcy, the executives managed to stay in the black, because of the structure of their performance-compensation pay contracts.

The authors point out that the ability of executives to make lots of money by pursuing highly risky strategies and their ability to avoid losses when their risky strategies lead to financial disaster are very bad news for the shareholders. This is the point I want to emphasize here. The shareholders, the owners of the company, gave bad incentives to their managers, and once a fiscal panic came about, the owners lost big.

But they were not the only ones to lose. The risky actions of executives such as those at Lehman (and they were not the only ones to be overly aggressive in taking risks) magnified the financial panic, once it had started, which resulted in the major recession we are still enduring. All of us lost.

Bebchuk, Cohen, and Spamann conclude that executive compensation schemes should be changed to give executives better incentives. This is certainly correct but it does not go far enough. Since the bad incentives created by such pay structures affect everybody, it is really a general reform of the mechanisms for performance pay throughout the economy that is indicated. Mechanism design theorists have the tools to suggest possible solutions. These tools are not a panacea, but they would certainly result in a safer financial system if applied carefully.

The biggest problem is probably political. As the Democratic administration moves to consider financial reform, after getting health reform passed, the Republicans are likely to resist meaningful reform. This is a basic issue with all mechanism design. Indeed, mechanism design theory starts with the assumption that a plan on how the system should be made to work has been agreed upon by society and the remaining problem is only technical: how to give people the right incentives so that the plan is achieved. This, and the reliance of mechanism design theory on classical game theory with its hyper-rational model of players, are the two biggest hurdles in coming up with mechanisms that deliver optimal incentives.